What caused the NASDAQ Internet Bubble of 1999?
The United States experienced an extraordinary surge in wealth in the 1990s that increased American’s net worth by 75 percent. John T. Wall, president of NASDAQ International, described the NASDAQ Internet Bubble as a “total breakaway with no rationale.”
It took sixty-eight weeks to go from 2000 to 3000; eight weeks to go from 3000 to 4000; and ten weeks to go from 4000 to 5000. NASDAQ peaked at 5048.62 on March 10, 2000, for 36 hours. Alice M. Rivlin, economic advisor to the Clinton Administration during the 1990s, said, “The world was treated to a vivid demonstration of how well free-market capitalism can work.”
But what goes up must come down. The NASDAQ crashed hard because the supply of the less experienced, less sophisticated, “marginal investors ready to buy overvalued stocks, had dried up.” And investors lost confidence in the securities markets in the wake of significant accounting scandals and bankruptcies. Various numbers are given for the total amount of wealth lost in the United States.
Henry Paulson, chairman and CEO of the Goldman Sachs Group at the time, estimated that investors lost over $7 trillion after the market’s peak in March 2000. Tech leaders Microsoft, Intel, and even Cisco alone saw more than a trillion dollars in market capitalization wiped out.
In 2002, almost 70 percent of the U.S. households had investments, in one way or another, in public equity markets. The average loss per household in the United States was $63,500; Massachusetts lost the most at $138,100 per household, and California lost $112,500 per household.
Some compare the fundamentals of the NASDAQ Internet Bubble to the great tulip mania of 1636–1637 in Amsterdam, when inflated prices of exotic tulip bulbs crashed on rumors of government intervention. We instead refer you to Ludwig von Mises, another Austrian economist, who stated that a cyclic downturn is a “cluster of errors.” The cluster of errors we witnessed in the late 1990s was “something that we will never see again in our lifetimes.” It was, in fact, a “perfect storm.”
Going Into the Eye of the Perfect Storm
A perfect storm is said to be one in which all the worst possible weather elements converge at the same time and place to create the mother of all atmospheric calamities—everything that can go wrong, does. Three elements converged in the late 1990s to create the Perfect Storm. There was “Internet anxiety” based on the commoditization of the Internet and fears that the “Y2K” problem would trigger a meltdown in the world’s economy. The second element was the democratization of capital for entrepreneurs. Money was everywhere and investors were hot to invest. The third element was the triggering event that set off the Perfect Storm. It was the race to go public, following Netscape’s initial public offering (IPO).
Commoditization of the Internet
The Internet was the greatest disruptive technology to hit the world since electricity. John Doerr from Kleiner Perkins described it as “the most powerful two-way global communication medium that we have witnessed, and probably will witness, in our lifetime.” America’s business leaders were some of the first to see it as a revolution in the making, and their comments fueled the “Internet anxiety.”
Bill Gates called the popularity of the Internet the most important single development in the computer industry since the IBM PC was introduced in 1981. “Like the PC, the Internet is a tidal wave. It will wash over the computer industry and many others, drowning those who don’t learn to swim in its waters.”
John Chambers, CEO of Cisco Systems, was quoted saying, “The Internet is not just a nice productivity tool. This is about survival.”
Jack F. Welch, chairman of General Electric, was quoted in 1999 as saying that the Internet “was the single most important event in the U.S. economy since the Industrial Revolution.”
Thus technology was sold on fear. A lot of technology was sold. IT buyers were spending at roughly double the historic rate of IT investment: about 5 to 6 percent of a company’s revenue, as compared to the historic rate of about 3 percent. In 2000 alone, ICT investment in the United States soared to $813 billion, or about $2,924 for every man, woman, and child.
According to Regis McKenna, ICT as a percentage of nominal business capital equipment spending peaked at 53 percent in December 2000, 48 percent above the forty-year trend line. Official statistics from the U.S. Bureau of Economic Analysis (BEA) reported that total spending on business equipment and software accelerated to a growth rate of over 12 percent, accounting for more than one-fourth of total Gross Domestic Product (GDP) growth between 1995 and 2000.
The ICT spending boom was also fueled in part by concern over the “Year 2000” (Y2K) computer meltdown, the prospect that companies’ “mission-critical” operations would be halted if computers misread 2000 as 1900. Economist Arthur B. Laffer reported that the U.S. Federal Reserve believed the Y2K problem was serious; they anticipated widespread computer failures and runs on banks. The government estimated it was going to cost $6.8 billion to fix the Y2K bug in the legacy computer systems of federal agencies alone.
Estimates in 1998–1999 for fixing the bug in the corporate world ranged from $52 billion to as high as $600 billion. Chase Manhattan Bank was budgeting to spend $200 million to $250 million. And rather than making bare-minimum upgrades, or remedying the Y2K problems, many companies spent heavily on complete next-generation computer systems. In fact, too much was spent. Morgan Stanley estimated that companies overspent on technology by $130 billion in 1999 and 2000.
Democratization of Capital
By its nature, and definition, venture capital thrives on capital gains, which in turn rely on the explosive growth of new business ventures. So like a huge tropical hurricane crossing warm water and growing even larger as more water gets sucked up into the eye of the storm, thus feeding the intensity of the storm, the democratization of entrepreneurs’ access to capital fueled new business venturing, which in turn fueled the Perfect Storm’s growth.
According to Mark Heesen, president of the National Venture Capital Association (NVCA) at the time, during the Perfect Storm $250 billion was being pumped into emerging growth ventures from venture capitalists, angel investors, and corporate investors. Between 1994 and 2001, Internet-related investment activity alone totaled a staggering $175 billion. The majority, 48 percent or $84 billion, flowed into Internet-related ventures in 2000, compared to the early days of the Internet in 1994, when venture capitalists invested only $556 million in Internet-related deals.
This activity peaked in the fourth quarter of 1999, when as much as $160 million was invested each day in about fourteen ventures, for an average of about $11.6 million each. Or looked at another way, in 1995 the most venture capital raised by a venture in a single round of financing was roughly $85 million; in the eye of the Perfect Storm such a deal would not even have been close to the top of the day’s press releases.
According to John Taylor, vice president of research at NVCA, the U.S. venture capital industry experienced one of its best years ever in 1999. But there was a fine line to walk between being in and being out. The VCs basically could not afford to have their money sitting on the sidelines when the times were hot.
According to Brad Jones, was a partner at Redpoint Ventures’ office in Los Angeles, “They have got to be in on the action when the action gets hot.” And during the Perfect Storm, “Everybody wanted to play in the venture business.” Between 1995 and 2001 the number of VC firms grew 90 percent as 359 were added to the industry. The average firm size grew 225 percent, from $103 million under management to $333 million, and the number of principals managing these firms grew 154 percent—from 3,498 to 8,891. So did their workload as the average amount managed per principal grew from $10 million to $28 million.
Taylor provided us these comments; “The industry grew very rapidly during that period. Venture funds were able to digest and put to use the amounts of money they were raising.” But did investors really put that money to good use? One consultant to entrepreneurs said in 1999, “You’re fighting just to have investors remember who the hell you are when they write the check two weeks later.”
Race to Go Public
The old line with investment bankers on Wall Street is, “When the ducks quack, you feed them.” Never was the quacking louder than during the race to go public in the late 1990s, and the ducks got fed as the IPO markets heated up. Since 1990, investment banks have raised nearly $24 trillion. Bill Gates once said, “People are jumping into the market like it’s a gold rush.” And gold investors found. Between 1996 and 2001, nearly $140 billion was returned on venture capital investments alone, 47 percent of which was returned in 2000. NASDAQ IPOs raised an all-time high of $54 billion in 2000, which was 24 times as much as in 1990.56 Between 1995 and 2001, 439 dot.coms went public, raising $34 billion.
Netscape proved that dot.com ventures were good investments, and its skyrocketing IPO triggered Wall Street’s five-year dot.com mania. Their sales campaign was simple. James L. Barksdale, CEO of Netscape, recalled that every businessperson he talked to was filled with greed or fear when it came to the Internet. They were asking, “How do I do it to them before they do it to me?” Netscape made $75 million in sales the first year, $375 million the second, and just over $500 million in their third year. Netscape had grown in three years to be the same size that it took Microsoft eleven years to reach.
As Michael Lewis wrote in The New Thing, Netscape’s IPO made 1980s’ Wall Street seem like a low-stakes poker table. On August 9, 1995, the IPO shocked the world as the company’s stock price opened well above its strong $28 offering price at $73, surged as high as $75, and closed at $58. (Three months later it was at $140.) Closing at a market value of $1.07 billion, it was one of the most successful IPOs in the history of the U.S. stock markets, and that’s before it had made even one dollar in profits.
Netscape, the fifteen-month-old venture’s IPO made the front page of The Wall Street Journal: “It took General Dynamics Corp. 43 years to become a corporation worth today’s $2.7 billion. It took Netscape Communications Corp. about a minute.”
Netscape’s IPO was “the start of Year One in the Online era,” and it “launched the Web in the mind of the public.” In a little more than 2,000 days after, the world created some three billion Web pages on 20 million Web sites. Doing business in “Netscape Time” became the inescapable process of rushing and working tremendously hard to get to IPO. The feeling inside Netscape before its IPO was nothing but “steady acceleration, with ever decreasing time periods between the initial product going to market and the company itself going to market.” Netscape Time was spreading. Said one CEO in 1999, “The idea of a competitor beating us to an IPO is very threatening.” This race to IPO was driven ever faster in part by the rising importance of stock options as a major form of compensation in the Silicon Valley. Twenty-four-year-old Marc Andreessen, co-founder of Netscape, was worth some $80 million after his company’s IPO.
The Good, the Bad, and the Ugly
During the Perfect Storm, more money was made available to invest, so people moved down the risk curve. Money was returned and more money was put back into riskier investments. Andrew McAfee, an assistant professor at Harvard Business School’s technology and operations management unit, put it this way: “We will never see again a wave of enthusiasm and investment and speculation that rises and crashes the way the first Internet wave did.”
We can take away three broad lessons from the Perfect Storm: the good, the bad, and the ugly.
First the good. As William Draper III, general partner at Draper Richards and managing director of Draper International, said, “It’s been a fabulous period for the encouragement of entrepreneurship, and that is the route of success of the economic system in the United States.” The Perfect Storm actually helped usher in the real “new economy,” where businesses, schools, and government agencies from around the world are steadily integrating Internet technologies into their normal business operations. And the dot.com crash did not kill anything except thousands of ill-conceived ventures and halted millions of business plans in the works. In 1999 Louis V. Gerstner, Jr., chairman at IBM, described the new Internet-only ventures that were going public at the time as “fireflies before the storm.”
The bad was the loss of entrepreneurial discipline during the Perfect Storm. Venture capitalists threw caution to the wind and lowered the “validation bar” to getting funded. Bridget Karlin, serial entrepreneur and now venture capitalist, said, “We venture capitalists did a great disservice to entrepreneurs and entrepreneurship, funding ventures that were just in the idea stage.” Rob Glaser, who founded Progressive Networks in 1994, said, “In 1995 and 1996, if you said you were doing an Internet toaster, I’m sure you could find a venture capitalist to fund it.”
Everyone was racing to IPO “in Netscape Time,” neglecting basic fundamentals to entrepreneurship. Sandy Robertson, who founded Robertson-Stephens investment bank, said this during the Perfect Storm: “With this huge injection of capital, companies are going public faster. And they don’t have to perform quite as well. If you’ve got the cash, you can erase the mistakes.” And comments from Adam Reinebach, vice president of research at Venture Economics, support Robertson’s. He said, “Back in late 1999 and early 2000, venture capitalists were really in a win-win situation when it came time to exit their investments. The IPO market was a virtual slam dunk, and there were plenty of companies with inflated stock values that were looking to grow through acquisition.”
This leads us to the ugly—the greed that surfaced and was leading the race to IPOs. William Hearst III, grandson of publishing magnate William Randolph Hearst and venture capitalist at Kleiner Perkins, told an audience of venture capitalists in 1999: “It’s an Oklahoma land rush. It’s not as much as how valuable the land is, but how much land you can grab.” Alan Patricoff, chairman of Apax Partners, a New York investment firm with $11 billion under management, helps us frame a closing to this chapter in the right direction by saying, “Real companies are built on earnings and cash flow. We gave away millions of dollars for crazy projects, and no one did the hard analysis of what companies could realistically earn. Rationality is coming back.”